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NYSE Tumbles to Underperform

Anxious over the sustainability factor, recently we downgraded our recommendation on NYSE Euronext Inc. to Underperform from Neutral.

The company’s first-quarter 2012 operating earnings per share of 47 cents fell shy of the Zacks Consensus Estimate of 49 cents and were substantially lower than 68 cents recorded in the year-ago quarter. Consequently, operating net income plunged 31.6% year over year to $121 million from $177 million in the year-ago quarter.

Results primarily reflected weak volumes and pricing across board, which also led lower top line and operating margins. Moreover, the increased market volatility has been sagging NYSE’s competitive position. However, lower expenses partially offset the downsides.

Over the past few quarters, NYSE has been affected by weak trading volumes, which is directly based on the economic and market conditions, volatility of interest rates, inflation, changes in price levels of securities and the overall level of investors’ confidence. Particularly, derivative volumes in the Europe and cash trading volumes in the U.S. sapped over the last few quarters and this is expected to continue given the ongoing debt-crisis in Europe and economic volatility in the U.S.

Furthermore, the current initiatives taken up by regulators and governments, such as restrictions on high frequency trading and taxes on securities transactions are liable to have a materially adverse effect on overall trading volumes. Also, the proposed MiFID II and EMIR legislations in Europe to make markets more competitive and negate systematic risks, the final adoption of which is expected by late 2012 or early 2013 will likely have a negative impact.

Moreover, NYSE’s top-line growth has been marred by consistent decline in transaction and clearing services and market data revenues along with lower-than-expected listing revenues that plummeted on lower listing fees and rate per contract, foreign currency fluctuations, lower margins, decreasing trading activity in derivative and cash trading and market competition.

Equity trading across the globe poses weakness primarily due to deteriorating credit quality that further impacts liquidity and matched share volume adversely. Economic volatility, in combination with intense competition, has also led to a decline in the size of securities offerings, new listings, trading volumes and related revenues. We do not expect any radical growth on the top line unless the current market recovery provides resonance to liquidity and credit quality.

Additionally, NYSE has been facing intense market pressure and that was evident from its inability to culminate significant business developments. Recently, NYSE was also shoved off the bid to acquire London Metals Exchange. More significantly, the year-long hustle to culminate the company’s merger with Frankfurt-based Deutsche Boerse was declared unsuccessful in February 2012. Adversely, the failed deal added to several expenses, thereby weighing on the margins.

NYSE has a bigger debt burden than its prime peer CME Group Inc. (CME - Free Report) . Presently, higher debt and capital expenditure have raised the financial leverage to 26.06%, whereas NYSE’s debt-to-EBITDA ratio deteriorated to 2.0x at the end of the first quarter of 2012 from 1.6x at 2011-end, which again underscores ample financial and operating risks. A risky financial and operating leverage could also shake the investors’ confidence, and call for an appropriate check and control system right away.

However, NYSE continues to grow organically as well as through mergers, acquisitions and alliances. While the recent acquisitions and alliance are expected to boost fundamentals, the technology will remain the fastest-growing segment for the combined entity and the company’s enhanced investment into the non-core space of this segment should also enhance long-term earnings accretion.

Management projects a double-digit revenue growth from the information and technology segment for 2012 along with an increased internationalization of client base. Going ahead, an improvement in the admission and annual fees to the exchange should also provide strong support to the top line.

Besides, NYSE continues to drive its operating leverage through strong expense management, headcount reduction and lower taxes. Consequently, the company’s total operating expenses declined about 37% year over year in 2009 followed by a 19% dip in 2010.

Although expenses rose marginally by 3% in 2011, it does not indicate a long-term trend as management’s expense guidance for 2012, despite the capital investment initiatives, signals a downward trend. Moreover, annual cost savings from new business initiatives worth $250 million and additional profits from the retail derivative market by the end of 2014 are also expected to drive margins in future.

NYSE also aims to augment long-term growth strategies by developing clearinghouse in Europe, enhancing technology and risk-management services and launching retail derivative market, among others. Hence, considering all the pros and cons, the Zacks Consensus Estimate pegs earnings for the second quarter of 2012 at 52 cents, which is way below 61 cents recorded in the year-ago quarter. Of the 14 firms covering the stock, 5 revised their estimates downward in the last 30 days, while a couple of upward revisions were witnessed.

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